The Fractional Reserve Aspects of Gold ETFs

December 16, 2009 – One of the best explanations of fractional reserves comes from a polemical essay written in 1995 by Murray Rothbard, one of the prominent champions of the Austrian School of Economics: “Banks make money by literally creating money out of thin air, nowadays exclusively deposits rather than bank notes. This sort of swindling or counterfeiting is dignified by the term ‘fractional-reserve banking,’ which means that bank deposits are backed by only a small fraction of the cash they promise to have at hand and redeem.”

Rothbard goes on to explain: “An honest warehouse makes sure that the goods entrusted to its care are there, in its storeroom or vault. But banks operate very differently.” Specifically, a bank only keeps in reserve a small portion of the money deposited with it, which makes banks inherently volatile.

Evidence of this volatility recurs throughout monetary history in the devastating bank ‘panics’ in which depositors rush to withdraw their money, like occurred in Britain just two years ago at Northern Rock Bank. Given the thin reed of confidence upon which bank solvency rests, these so-called ‘bank runs’ can arise at any time. But depositor flights to safety appear most frequently during the economic ‘bust’ that inevitably follows the ‘boom’ induced by excessive bank lending – bank lending made possible through the reckless practice of maintaining only fractional reserves.

One could argue that banks are in the business of lending, not storing. But that argument misses the point. Namely, fractional reserves are not essential to a bank’s goal to lend. Banks could just lend what depositors place with them without – to put it in Rothbard’s words – the “swindling or counterfeiting” that arises from “creating money out of thin air”.

People everywhere, however, have become so blinded by pro-banking propaganda that few question this practice, with the consequence that nearly everyone accepts the false doctrine that banking as it is now practiced is essential for economic growth. Well, when you can create money out of thin air it stands to reason that you can purchase a lot of propaganda. As Dr. Lawrence Parks of FAME.org puts it: “Monetary economists, for the last fifty years or more, have been bought off.” But I am not writing here to take aim at banking as it has devolved and is now practiced. Having provided this background information describing fractional reserves, I instead will explain why the gold exchange-traded funds (ETFs) are also a fractional reserve scheme.

Much has been said and written about whether the gold supposedly backing the ETFs really exists. Questions have been raised by me and others whether the banks acting as custodians for the gold backing the ETFs have really been storing that gold instead of lending it. A thorough reading of the GLD prospectus, for example, makes clear the many loopholes arising from the dark art of legal double-talk. Here are some interesting observations about GLD suggesting that these analyses of various ETFs’ gold-backing may be on to something.

On December 31, 2008, gold was $869.75 and GLD recorded ownership of 780.2 tonnes of metal, which by April 6, 2009 grew to 1127.4 tonnes. Curiously, defying the basic economic principle that increasing demand causes the price to rise, the gold price barely moved during this period, as its price on April 6th was $870.25. A 44.5% increase in tonnage recorded by GLD over three months moved the gold price by only $0.50, or only 0.06%.

Looked at from another perspective, during these 96 days, world gold production was about 638 tonnes, or 561 tonnes excluding the 12% mined in China that is not made available for sale in world markets. So GLD’s tonnage increase was 62% of available world production during that 96-day period, and yet the gold price barely moved. But there is more.

GLD now has 11 tonnes less gold than it recorded on April 6th. Yet the gold price since then has risen $251.75, or 28.9%.

To put the above observations into statistical terms, from the end of last year through December 15th, the correlation coefficient between the price of gold and GLD’s recorded ownership is 0.468. In other words, their correlation is tenuous, which should cause everyone to re-think a basic premise widely attributed to GLD.

This statistical evidence suggests that increases in the demand for GLD do not cause the gold price to rise. Carrying this line of reasoning further, given that in the final analysis it is the demand for physical gold that determines the gold price, one has to wonder whether GLD is fully backed by gold, and perhaps whether its shares are issued against promises to deliver gold in the future.

With this hard statistical evidence it is difficult to refute the view that GLD is a paper-gold product, but let’s overlook for the moment the uncertainties surrounding how much physical metal really backs GLD and just assume that all the gold backing this ETF really does exist. The reality is that GLD and the other gold ETFs are still a fractional reserve scheme because ETF shares can be sold short.

To explain this point, let’s assume you intend to buy GLD thinking that your shares are backed by gold. At the same time, a speculator who thinks gold is about to fall and aims to profit from the falling price, borrows shares from an existing GLD shareholder to sell short.

To illustrate this example, you buy 100 GLD shares (which are backed by 10 ounces of gold). But instead of buying shares from their owner, assume instead the shares you purchase have been borrowed from their owner and are being sold short by a speculator. So both you and the original owner now own the same 100 shares. More to the point, those 100 shares with two different owners are only backed by 10 ounces of gold. So who really owns those 10 ounces of gold? Both shareholders think they do!

So even if all the gold supposedly backing each share of GLD is properly accounted and really exists, to the extent that GLD is sold short, it is a fractional reserve scheme. It is therefore paper-gold, not real gold. GLD is a financial asset; it is not a tangible asset.

Consequently, do not buy GLD or the other gold ETFs thinking that your shares are backed by gold because short-selling means more people own shares than there is gold backing those shares. This conclusion does not mean, however, that the gold ETFs are not useful.

They can of course be useful, just like a gold futures contract can be useful. The gold ETFs and a gold futures contract both give the holder exposure to the gold price. But ask yourself one key question before buying any gold-related asset. Namely, what is my investment objective?

If you are a speculator or professional trader attempting to generate profits from gold’s price fluctuations, then by all means look at and compare the different alternatives like the gold ETFs, gold futures, options and other paper-gold trading vehicles. Otherwise, if you are seeking the safety and security attributes that derive from gold’s essential nature as a tangible asset, the only way to achieve this objective is to buy physical gold. One always needs the right tool to accomplish the task at hand.

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My objective is to share with you my views on gold, which in recent decades has become one of the world’s most misunderstood asset classes. This low level of knowledge about gold creates a wonderful opportunity and competitive edge to everyone who truly understands gold and money.